What is Due Diligence?
Due Diligence is a vital component when considering whether or not to invest in a company. It is something that, if performed correctly, can save an investor from spending capital on poor investment decisions. It is not necessarily the most exciting part of the deal process, but it is possibly the most important – at least for the investor. Due diligence can be understood as the comprehensive review of a company prior to making an investment. Generally, it comes later in the deal process, when the company has made it past the early stages of investment consideration (meeting with founders and/or a formal pitch to the fund).
If a company is fortunate enough to make it to the due diligence phase, the investor will request many or all the company’s documents, including: the business plan, financial statements (if there are any), legal documents, and anything else the company can produce. It is important to note, while these documents are important, they appear to be increasingly less important in the screening process. For example, the necessity of having a full business plan to obtain funding is becoming less and less common.
Additionally, it is important to keep in mind that the actual due diligence process varies for each firm. Some investors may be very insistent on digging through the financial statements and ensuring that high standards of certain metrics are met. On the other hand, some investors may take a more personal approach, choosing to focus their assessments more on the product and founders of the company.
Most investors will utilize a checklist to refer to while looking at companies. This will include items such as: background checks on founders, evaluating the company’s intellectual property, determining whether the company has product-market fit, and, of course, reviewing the company’s finances. The checklist could be short and simple, or very exhaustive depending on how heavily the investor wants to investigate.
This begs the question, how much due diligence should an investor perform? At what point is the investor under or overdoing it? Certainly, this will be a matter of preference in most cases. However, while we may not be able to say for certain what is the perfect amount of due diligence, we ought to identify how much is too much, or too little. Additionally, we can identify certain factors in a deal that warrant more comprehensive or less comprehensive reviews.
Not Enough Due Diligence
A clear example of not doing enough due diligence is failing to request any of the company’s documents. This may seem obvious, however there are certainly stories of investors ignoring due diligence for the sake of joining in on a closing round. Undoubtedly, this is a not a good practice for investors. A 2007 study by the Angel Capital Association found that investments in which 20+ hours of due diligence was conducted were five times more likely to result in a positive return compared to investments made with less due diligence. Considering this, an investor that is committed to generating positive returns cannot dismiss the importance of due diligence on potential investments.
Too Much Due Diligence
However, in conducting due diligence there is a point of diminishing marginal returns. In fact, investors should be equally cautious that they aren’t conducting too much due diligence. What does too much due diligence look like? This depends – largely in part by how much the investor is considering investing. For example, if an investor is considering making a $1m+ investment in a startup company, this may warrant a due diligence process of several months. However, if an investor is making smaller investments ($75k and under), the due diligence process should be limited to 1 month or less in most cases.
The main problem with a due diligence that drags on for several months is it distracts the entrepreneurs from what they ought to be focusing on – building the company! If the investors are overwhelmingly reaching out to the entrepreneurs with requests, documents and questions they are taking away valuable time that could be spent building the product, generating sales, etc. If this be the case and the investor is limiting the entrepreneur’s ability to build the company, then they are reducing the already low chances that the company will grow and generate a return for the investor. In simple terms, too much due diligence can reduce an investor’s ability to produce positive returns.
Due Diligence at Rebel Venture Fund
We’ve recognized that there is a possible correlation between the amount of due diligence an investor conducts with the number of positive returns the investor sees. The point at which the amount of due diligence begins having adverse effects is less clear but certainly exists. Recognizing this, the Rebel Venture Fund has decided to adjust our due diligence process in a way that maintains the importance of conducting a thorough due diligence while also making the process less demanding for the entrepreneurs.
Our new due diligence process will involve a pre-diligence (phase 1) in which a small team will meet with the entrepreneurs and do a high-level review of the company, including: its business model, management team, and competitive analysis. This stage should take no longer than 1-2 weeks. If the due diligence team likes the company, the entrepreneurs will get a chance to pitch to the fund. After this, the fund will have a more concrete idea if we would like to invest in the company.
The process will be completed with a 1-2 week post-diligence (phase 2) in which the final due diligence documents will be collected and analyzed for any outstanding red flags. This would include items such as: financials, contracts, IP evaluation, and any other legal documents.
Prior to adapting this format, our due diligence process would often take 6-8 weeks depending on the circumstances of the deal. The goal is that the new format will be less of a burden on the entrepreneurs by front loading much of the due diligence process. At the same time, we will still maintain a thorough review of the company, as this is crucial to catching red flags and not making poor investment decisions. Thus, if the new process goes as planned, it should result in entrepreneurs with more time to focus on growing their companies and investors with better overall returns.
About the Author
Cody Massey is a Director at the Rebel Venture Fund and an Accounting/Finance student at the University of Nevada Las Vegas. In addition to RVF, Cody is heavily involved throughout many organizations and programs at UNLV, including: Student-Athlete for the Men’s Soccer team, Chief of Staff for the Student-Athlete Advisory Committee, Honors College Mentor Scholar, as well as International Ambassador and Lee Scholar for the Lee Business School. Upon graduating, Cody plans to pursue a career in investment banking and other areas of finance.
Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of RVF or UNLV. In addition, thoughts and opinions are subject to change and this article is intended to provide an opinion of the author at the time of writing this article. All data and information is for informational purposes only.